Bond Market Underestimating Nut Factor

July 19, 2011

The widespread assumption in the bond market that the debt ceiling showdown will, somehow, some way, end well strikes me as a classic underestimation of risk. We quietly assume that something terrible and pointless won't happen because it's never happened before, even if the potential causes of disaster are blindingly obvious. Jonathan Allen and Jake Sherman have a good story about the craziness of the Republican caucus. How crazy are these people? So crazy that the current House plan -- to tie a debt ceiling hike to a Constitutional amendment to balance the budget every year and impose a California-style supermajority to increase taxes -- is running into GOP dissent from the right:

Even some rock-ribbed conservatives believe it doesn’t go far enough: Rep. Steve King (R-Iowa) told POLITICO Monday night that he was leaning “no.”

How crazy are they? So crazy they're using the metaphors of a crazy man:

The senior House GOP aide said “the only reason” McConnell’s plan isn’t dead on arrival in the House is “because there are so few outs” to avoid a default.

“They’re in punt formation. If they’re in punt formation, we’re going to blitz,” said Chaffetz, a former college football kicker.

What does that even mean? You don't blitz against a punt formation -- you either try to block the kick or return it. You blitz when the opponent is running a play from scrimmage. Is Chaffetz saying the House GOP wants to to go after the Senate GOP? That the House GOP wants to confuse the opposition by doing something that makes no sense?

Most Republican voters believe that failing to lift the debt ceiling will not cause any major economic harm. In their view, lifting the debt ceiling is a massive policy compromise, one that allows harmful deficit spending. It's certainly not something they think their party should do in return for another compromise (like tax increases.) And most Republicans in Congress may know better, but it's unclear what is going to make them risk their careers over it.

Another point to keep in mind is that the Obama administration, and especially the Treasury Department, has been making soothing noises for months about the inevitability of lifting the debt ceiling. Financial markets probably interpreted this as the expression of a secret understanding with the Republicans that this whole debt ceiling process was a charade. I suspect the administration has simply been saying whatever it needs to say to forestall a market freakout.

I do think they'll probably make a deal. But the state of the financial markets seems to be pricing in a likelihood of a deal way higher than "probably."